ECB's Covered Bond Pledge Kick-Starts Issuance

The European Central Bank (ECB) bought €2.9 billion ($4.10 billion) worth of covered bonds in July - the first purchases under a plan to purchase €60 billion worth of covered bonds over the next year.

The program's success comes with a revival of new covered bond issuance and spread tightening.

Even the Spanish Cedula space, which has not seen any issuance since 2007, has benefited from the revival of the European covered bond market.

AyT Cedulas Cajas is back with a new transaction after a two-year hiatus from the Jumbo primary market.

According to market reports, the issuer was able to secure triple-A ratings while the older tranches of AyT's global program are under review for potential downgrade, by means of a new overcollateralization commitment.

To counter potential rating concerns on the part of investors, the individual issuers involved in the new AyT issue have, for the first time, committed themselves to maintaining overcollateralization levels compatible with a Moody's Investors Service 'Aaa' rating.

"The market has begun to see new issues from product segments that were up to now banned from market access, such as Spanish Cedulas," said Ted Packmohr, head of covered bonds research at Dresdner Kleinwort. "Whereas Jumbo issuance had become pretty much an exclusively German and French game at the beginning of the year, the primary market has therefore regained some of its former regional breadth."

ABN Amro Bank, which has been absent from the market for two years, also issued a €2 billion, five-year covered bond via joint leads Deutsche Bank, Natixis and Royal Bank of Scotland Group.

"The investor base for covered bonds is much more solid than that for ABS," said Jean-David Cirotteau, a structured finance analyst at Societe Generale. "This has been demonstrated in the recent crisis: Despite the covered bond market being temporarily interrupted, it has recovered more quickly and is faring better than the ABS market - though both routes should be reopened. But, market recovery needs to be orderly, and the ECB is dealing with the issue step by step."

Packmohr added that the risk of spreads being hit by the usual wave of issuance in September appears fairly limited, but warned that the ECB program won't resolve all the challenges the covered bonds space faces.

"To be sure, this is no panacea to setbacks such as the current outright losses on the bond markets," he said. "Yet in this case too, covered bonds were relatively less impacted by the general yield increase than Bunds [German government bonds], for instance." He added that the strong covered bond performance also gives rise to the question of when profit taking may be worthwhile and when a switch into other segments would make sense.

For example, the extra yield that investors demanded to hold covered bonds rather than similar-maturity government notes has plummeted in the two months since the ECB announced its program.

According to Merrill Lynch's EMU Pfandbrief Index, the spread tightened to 85 basis points, from 111 basis points when the ECB announced the purchase program in May.

Packmohr said that the spread differentials between German Pfandbrief and these state-guaranteed bonds have continued to fade away and, in some cases, are no more than 10 basis points.

At the same time, the rating stability in these state-guaranteed bonds is considered superior when compared to the covered bonds segment, which is still likely to see several rating adjustments.

"Nevertheless, apart from rating-sensitive investors, we still find it difficult to find convincing arguments to expect a significant outperformance of state-guaranteed government bonds versus Jumbos in the short term that would justify the bid/offer costs and a still-existing loss of pick-up when switching out of covered bonds," Packmohr said.

Australian Covered Bonds

Earlier this month, the Australian Securitization Forum had issued a proposal to develop the Australian covered bond market as a solution to the country's moribund RMBS market.

The lack of current legislation in Australia is due to the reluctance of regulators to create a range of secured investors that are senior to bank depositors. However, Cirotteau said that there are potential issuers for covered bonds that could include the four largest national banks plus Suncorp Metway.

Initiatives for smaller issuers regarding a government guarantee for RMBS to offset the approaching end of the Australian Office of Financial Management purchase program are also under discussion.

"Interestingly, these two approaches show the differences between the European and Australian markets," Cirotteau said. "The ECB is clearly trying to restart the covered bond market, which has the most developed investor base - exactly the opposite of Australia."

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